Portfolio Manager CommentaryMay 10th, 2019 by Jonathan Chatfield, CFA
This past week, worries about trade tensions with China have elevated stock market volatility. President Trump announced tariffs on $200 billion in Chinese goods will rise from 10% to 25% at 12:01 am on Friday, May 10th, due to a lack of commitment by China. China appeared to be backtracking on key agreements concerning intellectual property rights and currency manipulation. In response, China pledged to retaliate. Unfortunately, the US consumer and economy would be the loser if tensions escalate further. Tariffs increase costs to U.S. manufacturers and consumers and lower demand for US goods abroad.
We are concerned that until a new trade agreement with China is in place and tariffs are dropped, we are looking at a higher risk of economic slowdown, which in turn could lower earnings growth projections and pressure stock prices. U.S. stocks had rallied in April as the U.S. and China appeared to be on the cusp of a trade agreement. Actions this week have resulted in more market uncertainty, however trade talks aren’t dead and a resolution that satisfies both sides may still be possible.
In our portfolios, we are transitioning to a more conservative equity position consisting of a lower allocation to equities in general along with an increase in our allocation to traditionally more defensive sectors (health care and consumer staples). Additionally, we are reducing our positions in traditionally more growth-oriented sectors (telecommunications services and consumer discretionary).
The Fixed Income portion of the portfolio serves two purposes: income and diversification. Diversification means an offset to the volatility of your equity investments. To the greatest extent possible we want to reduce overall portfolio volatility by investing in the sectors of the bond market that have the lowest correlation to equities, which means we use more low risk bonds and less higher risk bonds. The result of our strategy is that at times it may underperform the benchmark, which includes the risker issues (longer term and a greater exposure to corporate bonds).
Traditionally we orient the fixed income investments with a focus on safety of principal and current income. When we buy individual bonds we have been selecting primarily U.S. treasury securities and short-term investment grade corporate bonds. In comparison to the benchmark, Barclays U.S. Aggregate Bond Index, our fixed income portfolios have lagged this year after outpacing the benchmark in the 4th quarter. This is primarily due to our exposure to the most conservative segment (short term, investment grade corporate bonds, U.S. Government Agencies and Treasuries) of the bond market and lack of exposure to the riskier areas of the bond market (longer maturities, lower credit quality). At longer maturities, interest rate risk becomes a larger factor and with lower credit quality default risk becomes a larger factor. We don’t simply reach for maximum yield. We want to balance out the desire for total return versus the amount of risk we are willing to take.
Across the risk spectrum, high yield (junk) bonds and bonds of emerging market countries offer the highest yields, but at the same time the highest risk of loss and volatility. This results in a higher correlation to equities, which would produce less of a buffer against portfolio declines when equities fall.
Overall, we have adjusted our portfolios to reflect the current outlook based on our assessment of market risks and interest rate policy. We continue to believe short term treasuries, agencies and corporates offer the best risk adjusted return in the bond market. On the equity side we have reduced equity exposure and increased our positions in defensive stocks.